Are you preparing for Depreciation interview?. Depreciation is a study decrease in the value of something. Indian Rupee is getting depreciated now a days compared to USD. This is due to the increase in the prices in global market. Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value. Four methods of depreciation - straight line, units of production, sum-of-years-digits, and double-declining balance. There are number of people applying to Depreciation jobs. Wisdomjobs focus on providing interview questions and answers to help you in clearing the interview with ease. Depreciation interview questions are useful to attend job interviews and get shortlisted for position. Check out interview questions page to get more information.
The double declining balance method of depreciation, also known as the 200% declining balance method of depreciation, is a common form of accelerated depreciation. Accelerated depreciation means that an asset will be depreciated faster than would be the case under the straight line method. Although the depreciation will be faster, the total depreciation over the life of the asset will not be greater than the total depreciation using the straight line method. This means that the double declining balance method will result in greater depreciation expense in each of the early years of an asset's life and smaller depreciation expense in the later years of an asset's life as compared to straight line depreciation.
Under the double declining balance method, double means twice or 200% of the straight line depreciation rate. Declining balance refers to the asset's book value or carrying value at the beginning of the accounting period. Book value is an asset's cost minus its accumulated depreciation. The asset's book value will decrease when the contra asset account Accumulated Depreciation is credited with the depreciation expense of the accounting period.
Let's illustrate double declining balance depreciation with an asset that is purchased on January 1 at a cost of $100,000 and is expected to have no salvage value at the end of its useful life of 10 years. Under the straight line method, the 10 year life means the asset's annual depreciation will be 10% of the asset's cost. Under the double declining balance method the 10% straight line rate is doubled to be 20%. However, the 20% is multiplied times the asset's beginning of the year book value instead of the asset's original cost. At the beginning of the first year, the asset's book value is $100,000 since there has not yet been any depreciation recorded. Therefore, under the double declining balance method the $100,000 of book value will be multiplied by 20% for depreciation in Year 1 of $20,000. The journal entry will be a debit of $20,000 to Depreciation Expense and a credit to Accumulated Depreciation of $20,000.
At the beginning of the second year, the asset's book value will be $80,000. This is the asset's cost of $100,000 minus its accumulated depreciation of $20,000. The $80,000 of beginning book value multiplied by 20% results in $16,000. The depreciation entry for Year 2 will be a debit to Depreciation Expense for $16,000 and a credit to Accumulated Depreciation for $16,000.
At the beginning of Year 3, the asset's book value will be $64,000. This is the asset's cost of $100,000 minus its accumulated depreciation of $36,000 ($20,000 + $16,000). The book value of $64,000 X 20% = $12,800 of depreciation expense for Year 3.
At the beginning of Year 4, the asset's book value will be $51,200. This is the asset's cost of $100,000 minus its accumulated depreciation of $48,800 ($20,000 + $16,000 + $12,800). The book value of $51,200 X 20% = $10,240 of depreciation expense for Year 4.
As you can see, the amount of depreciation expense is declining each year. Over the remaining six years there can be only $40,960 of additional depreciation. This is the asset's cost of $100,000 minus its accumulated depreciation of $59,040. Some people will switch to straight line at this point and record the remaining $40,960 over the remaining 6 years in equal amounts of $6,827 per year. Others may choose to follow the original formula.
In manual accounting or bookkeeping systems, business transactions are first recorded in a journal...hence the term journal entry.
A manual journal entry that is recorded in a company's general journal will consist of the following:
These journalized amounts (which will appear in the journal in order by date) are then posted to the accounts in the general ledger.
Today, computerized accounting systems will automatically record most of the business transactions into the general ledger accounts immediately after the software prepares the sales invoices, issues checks to creditors, processes receipts from customers, etc. The result is we will not see journal entries for most of the business transactions.
However, we will need to process some journal entries in order to record transfers between bank accounts and to record adjusting entries. For example, it is likely that at the end of each month there will be a journal entry to record depreciation. (This will include a debit to Depreciation Expense and a credit to Accumulated Depreciation.) In addition, there will likely be a need for journal entry to accrue interest on a bank loan. (This will include a debit to Interest Expense and a credit to Interest Payable.)
The journal entry for depreciation contains a debit to the income statement account Depreciation Expense and a credit to the balance sheet account Accumulated Depreciation.
The purpose of the journal entry for depreciation is to achieve the matching principle. In each accounting period, part of the cost of certain assets (equipment, building, vehicle) gets moved from the balance sheet to depreciation expense on the income statement so it can be matched with the revenues obtained by using these assets.
The account Accumulated Depreciation is reported under the asset heading of Property, Plant and Equipment. It is also known as a contra asset account because it is an asset account with a credit balance. Because Accumulated Depreciation is a balance sheet (or real or permanent) account, its balance will carry over to the next accounting period. This means that its credit balance could get as large as the cost of the assets being depreciated.
The income statement account Depreciation Expense is a temporary account. At the end of each year, its balance is transferred out of the account and Depreciation Expense will begin the new year with a zero balance.
It is important to realize that when the depreciation expense entry is recorded, a company's net income is reduced by the expense, but its cash is not reduced. (Cash would have been reduced when the asset was acquired.) You should also realize that depreciation is an estimate based on the asset's historical cost (not its replacement cost), its estimated useful life, and its estimated salvage value. The focus of depreciation is to allocate and match the cost to expense and it is not to provide an estimate of the current value of the asset. As a result, the market value of a one year old computer will likely be less than the remaining amount reported on the balance sheet. On the other hand, a rental property in a growing area might have a market value that is greater than the remaining amount reported on the balance sheet.
A contra asset account is an asset account where the balance will be either a credit balance or a zero balance. (A debit balance in a contra asset account will violate the cost principle.) Since a credit balance in an asset account is contrary to the normal or expected debit balance the account is referred to as a contra asset account.
The most common contra asset account is Accumulated Depreciation. Accumulated Depreciation is associated with property, plant and equipment and it is credited when Depreciation Expense is recorded. Recording the credits in the Accumulated Depreciation means that the cost of the property, plant and equipment will continue to be reported. Reporting the accumulated depreciation separately allows the readers of the balance sheet to see how much of the cost has been depreciated and how much has not yet been depreciated.
Another contra asset account is Allowance for Doubtful Accounts. This account appears next to the current asset Accounts Receivable. The account Allowance for Doubtful Account is credited when a company enters estimated amounts as debits to Bad Debts Expense under the allowance method. The use of Allowance for Doubtful Accounts permits a reader to see the documented amounts in Accounts Receivable that the company has a right to collect from its credit customers. The separate credit balance in the account Allowance for Doubtful Accounts tells the reader how much of the debit balance in Accounts Receivable is unlikely to be collected.
A less common example of a contra asset account is Discount on Notes Receivable. The credit balance in this account is amortized or allocated to Interest Income or Interest Revenue over the life of a note receivable.
When a fixed asset or plant asset is sold, the asset's depreciation expense must be recorded up to the date of the sale. Next, 1) the asset's cost and accumulated depreciation is removed, 2) the amount received is recorded, and 3) any difference is reported as a gain or loss.
Here's an example. A company sells one of its machines on January 31 for $5,000. The last time depreciation was recorded was on December 31. Depreciation expense is $400 per month. The general ledger shows the machine's cost was $50,000 and its accumulated depreciation at December 31 was $40,000.
On January 31 the company will debit Depreciation Expense for $400 and will credit Accumulated Depreciation for $400 in order to record the depreciation during January. In its next entry on January 31, the company will debit Cash for $5,000 (the amount received); debit Accumulated Depreciation for $40,400 (the balance at January 31); debit Loss of Disposal of Asset $4,600; and credit Machines for $50,000.
Let's step back and review the disposal of the machine. As of January 31, the machine's book value is $9,600 (cost of $50,000 minus its accumulated depreciation of $40,400). Because the asset is sold, the $9,600 of book value or carrying value is removed from the accounts. In its place, the company received and records the cash of $5,000. Since the company received $4,600 less than the amount it removed, it will report a loss of $4,600.
If the company had received more cash than the asset's book value, it would report the difference as a credit to Gain on Disposal of Asset.
Having an asset account such as Accumulated Depreciation allows a company's balance sheet to easily report both 1) the amount of an asset's cost that has been depreciated as of the date of the balance sheet, and 2) the asset's cost. This is possible because Accumulated Depreciation is credited each time that Depreciation Expense is debited. Since Accumulated Depreciation will have a continually increasing credit balance it is referred to as a contra asset account .
To illustrate, let's assume that at the beginning of the current year a company's asset account Equipment reports a cost of $70,000. From the time of purchase until the beginning of the year the related Accumulated Depreciation account has accumulated a credit balance of $45,000. During the current year the company debits Depreciation Expense for $10,000 and credits Accumulated Depreciation for $10,000. At the end of the current year the credit balance in Accumulated Depreciation will be $55,000.
By crediting the account Accumulated Depreciation instead of crediting the Equipment account, the balance sheet at the end of the year can easily report both the equipment's cost of $70,000 and its accumulated depreciation of $55,000. This is more informative than reporting only the net amount of $15,000 (which would likely be the case if the contra asset account Accumulated Depreciation was not used).
Depreciation on the income statement is the amount of depreciation expense that is appropriate for the period of time indicated in the heading of the income statement. The depreciation reported on the balance sheet is the accumulated or the cumulative total amount of depreciation that has been reported as expense on the income statement from the time the assets were acquired until the date of the balance sheet.
Let's illustrate the difference with an example. A company has only one depreciable asset that was acquired three years ago at a cost of $120,000. The asset is expected to have a useful life of 10 years and no salvage value. The company uses straight-line depreciation on its monthly financial statements. In the asset's 36th month of service, the monthly income statement will report depreciation expense of $1,000. On the balance sheet dated as of the last day of the 36th month, accumulated depreciation will be reported as $36,000. In the 37th month, the income statement will report $1,000 of depreciation expense. At the end of the 37th month, the balance sheet will report accumulated depreciation of $37,000.
Depreciation is the assigning or allocating of a plant asset's cost to expense over the accounting periods that the asset is likely to be used. For example, if a business purchases a delivery truck with a cost of $100,000 and it is expected to be used for 5 years, the business might have depreciation expense of $20,000 in each of the five years. (The amounts can vary depending on the method and assumptions.)
In our example, each year there will be an adjusting entry with a debit to Depreciation Expense for $20,000 and a credit to Accumulated Depreciation for $20,000. Since the adjusting entries do not involve cash, depreciation expense is referred to as a noncash expense.
Accumulated depreciation is the total amount of a plant asset's cost that has been allocated to depreciation expense since the asset was put into service. Accumulated depreciation is associated with constructed assets such as buildings, machinery, office equipment, furniture, fixtures, vehicles, etc.
Accumulated Depreciation is also the title of the contra asset account which is credited when Depreciation Expense is recorded each accounting period.
The amount of accumulated depreciation is used to determine a plant asset's book value (or carrying value). For example, a delivery truck having a cost of $50,000 and accumulated depreciation of $31,000 will have a book value of $19,000. (It is important to note that an asset's book value does not indicate the asset's market value since depreciation is merely an allocation technique.)
The accumulated depreciation of each plant asset cannot exceed the asset's cost. If an asset remains in use after its cost has been fully depreciated, the asset's cost and its accumulated depreciation will remain in the general ledger accounts and the depreciation expense stops. When the asset is disposed (sold, retired, etc.) the asset's cost and accumulated depreciation are removed from the accounts.
An expense is reported on the income statement. An expense is a cost that has expired, was used up, or was necessary in order to earn the revenues during the time period indicated in the heading of the income statement. For example, the cost of the goods that were sold during the period are considered to be expenses along with other expenses such as advertising, salaries, interest, commissions, rent, and so on.
An expenditure is a payment or disbursement. The expenditure may be for the purchase of an asset, a reduction of a liability, a distribution to the owners, or it could be an expense. For instance, an expenditure to eliminate a liability is not an expense, while expenditures for advertising, salaries, etc. will likely be recorded immediately as expenses.
Here's another example to illustrate the difference between an expense and an expenditure. A company makes an expenditure of $255,500 to purchase equipment. The expenditure occurs on a single day and the equipment is placed in service. Assuming the equipment will be used for seven years, under the straight line method of depreciation the cost of the equipment will be reported as depreciation expense of $100 per day for the next 2,555 days (7 years of service with 365 days each year).
Capitalized interest is the interest added to the cost of a self-constructed, long-term asset. It involves the interest on debt used to finance the asset's construction.
The details of capitalized interest are explained in the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards No. 34, Capitalization of Interest Cost. You can find this accounting pronouncement at www.FASB.org/st.
In short, there must be debt involved (cash and common stock are not considered). The interest specified by the pronouncement is added to the cost of the project, instead of being expensed on the current period's income statement. This capitalized interest will be part of the asset's cost reported on the balance sheet, and will be part of the asset's depreciation expense that will be reported in future income statements.
The cost principle is one of the basic underlying guidelines in accounting. It is also known as the historical cost principle.
The cost principle requires that assets be recorded at the cash amount (or its equivalent) at the time that an asset is acquired. For example, if equipment is acquired for the cash amount of $50,000, the equipment will be recorded at $50,000. If the equipment will be useful for 10 years with no salvage value, the straight-line depreciation expense will be $5,000 per year (cost of $50,000 divided by 10 years). The equipment's market value, replacement cost or inflation-adjusted cost will not affect the annual depreciation expense of $5,000. The company's balance sheets will report the equipment's historical cost minus the accumulated depreciation.
The cost principle also means that valuable brand names and logos that were developed through effective advertising will not be reported as assets on the balance sheet. This could result in a company's most valuable assets not being included in the company's asset amounts. (On the other hand, a brand name that is acquired through a transaction with another company will be reported on the balance sheet at its cost.)
If a company has an asset that has a ready market with quoted prices, the historical cost may be replaced with the current market value on each balance sheet. An example is an investment consisting of shares of common stock that are actively traded on a major stock exchange.
Depreciation expense is the allocated portion of the cost of a company's fixed assets that is appropriate for the accounting period indicated on the company's income statement. For instance, if a company had paid $2,400,000 for its office building (excluding land) and the building has an estimated useful life of 40 years, each monthly income statement will report straight-line depreciation expense of $5,000 for 480 months. [However, the allocated cost of the fixed assets used in manufacturing will be part of the manufacturing overhead which will become part of the cost of the products manufactured.]
Depreciation expense is referred to as a noncash expense because the recurring, monthly depreciation entry (a debit to Depreciation Expense and a credit to Accumulated Depreciation) does not involve a cash payment. As a result, the statement of cash flows prepared under the indirect method will add depreciation expense to the amount of net income.
The common methods for computing depreciation expense include straight-line, double-declining balance, sum-of-the-years digits, and units of production or activity.
The term impairment is usually associated with a long-lived asset that has a market which has decreased significantly. For example, a meat packing plant may have recently spent large amounts for capital expenditures and then experienced a dramatic drop in the plant's value due to business and community conditions.
If the undiscounted future cash flows from the asset (including the sale amount) are less than the asset's carrying amount, an impairment loss must be reported.
If the impairment loss must be reported, the amount of the impairment loss is measured by subtracting the asset's fair value from its carrying value.
In accounting, the concept of materiality allows you to violate another accounting principle if the amount is so small that the reader of the financial statements will not be misled.
A classic example of the materiality concept or the materiality principle is the immediate expensing of a $10 wastebasket that has a useful life of 10 years. The matching principle directs you to record the wastebasket as an asset and then depreciate its cost over its useful life of 10 years. The materiality principle allows you to expense the entire $10 in the year it is acquired instead of recording depreciation expense of $1 per year for 10 years. The reason is that no investor, creditor, or other interested party would be misled by not depreciating the wastebasket over a 10-year period.
Determining what is a material or significant amount can require professional judgment. For example, $5,000 might be immaterial for a large, profitable corporation, but it will be material or significant for a small company that has very little profit.
Generally, the difference involves the "timing" of the depreciation expense on a company's financial statements versus the depreciation expense on the company's income tax return. The depreciation expense in each year will be different, but the total of all of the years' depreciation expense associated with a specific asset will likely add up to the same total—the cost of the asset.
The book depreciation expense is the amount recorded on the "books" and reported on the financial statements. This depreciation is based on the matching principle of accounting. For example, if a machine costs $500,000 and is expected to be used for 10 years and to have no salvage value at the end of the 10 years, the annual depreciation expense might be $50,000 each year. (This assumes the straight-line method and that the machine was acquired on the first day of an accounting year.) Another company purchasing the same machine might believe that the machine will be useful for only 5 years and have $100,000 salvage value. In that case the company will record $80,000 ($400,000 divided by 5 years) each year. The two companies did their best to match the machine's cost to the accounting periods that the machine is being used to earn revenues.
The tax depreciation is recorded on the company's income tax returns and will be based on the Internal Revenue Service's rules. The IRS might specify that the machine is a 7-year machine regardless of a company's situation. The IRS rules also allow a company to accelerate the depreciation expense. Accelerated depreciation means taking more depreciation in the first few years and less depreciation in the later years of the machine's life. This saves income tax payments in the first few years of the asset's life but will result in more taxes in the later years. Companies that are profitable will find the accelerated depreciation to be attractive.
The accounting and IRS rules allow a company to use the 10-year straight-line assumption for the books and the 7-year accelerated method for the tax return. This leads some people to say the company is keeping two sets of books. Of course, the company must 1) maintain depreciation records for the book and financial statement depreciation based on the matching principle in accounting, and 2) maintain depreciation records for the tax return based on the IRS rules.
In some situations the IRS allows for the immediate expensing (the entire cost of the asset is deducted from taxable income in the year it is purchased) of assets up to a specific dollar amount. You can learn more about tax depreciation from www.IRS.gov or from a tax adviser.
Construction Work-in-Progress is a long-term asset account in which the costs of constructing long-term assets are recorded. The account Construction Work-in-Progress will have a debit balance and will be reported on the balance sheet as part of a company's Property, Plant and Equipment.
The costs of a constructed asset are accumulated in the account Construction Work-in-Progress until the asset is placed into service. When the asset is completed and placed into service, the account Construction Work-in-Progress will be credited for the accumulated costs of the asset and will be debited to the appropriate Property, Plant and Equipment account.
In accounting we use the word amortization to mean the systematic allocation of a balance sheet item to expense (or revenue) on the income statement. Conceptually, amortization is similar to depreciation and depletion. An example of amortization is the systematic allocation of the balance in the contra-liability account Discount of Bonds Payable to Interest Expense over the life of the bonds. (The accountant credits Discount on Bonds Payable and debits Bond Interest Expense with a portion of the balance each accounting period.) In the case of a premium on bonds payable, the accountant systematically moves a portion of the balance in Premium on Bonds Payable by debiting the account and crediting Interest Expense.
Amortization also applies to asset balances, such as discount on notes receivable, deferred charges, and some intangible assets.
Amortization is a term used with mortgage loans. For example, a mortgage lender often provides the borrower with a loan amortization schedule. This schedule lists each loan payment during the life of the loan, the amount of each payment that is for interest, the amount of each payment that is for principal, and the principal balance after each loan payment. The loan amortization schedule allows the borrower to see how the loan balance will be reduced over the life of the loan.
Property, plant and equipment is the long term or noncurrent asset section of the balance sheet. Included in this classification are land, buildings, machinery, office equipment, vehicles, furniture and fixtures used in a business. Also included in property, plant and equipment is the accumulated depreciation for these assets (except for land, which is not depreciated).
The assets reported as property, plant and equipment are described as long-lived, tangible assets. They are also described as fixed assets or as plant assets.
Generally, the property, plant and equipment assets are reported at their cost followed by a deduction for the accumulated depreciation that applies to all of these assets.
The depreciation of assets such as equipment, buildings, furnishing, trucks, etc. causes a corporation's asset amounts, net income, and stockholders' equity to decrease. This occurs through an accounting adjusting entry in which the account Depreciation Expense is debited and the contra asset account Accumulated Depreciation is credited.
The amount of the annual depreciation that is reported on the financial statements is an estimate based on the asset's 1) cost, 2) estimated salvage value, and 3) useful life. Depreciation should be thought of as an allocation of the asset's cost to expense (and not as a valuation technique). In other words, the accountant is matching the cost of the asset to the periods in which revenues are generated from the asset.
The amount of the annual depreciation reported on the U.S. income tax return is based on the tax regulations. Since depreciation is a deductible expense for income tax purposes, the corporation's taxable income (and associated tax payments) will be reduced by its tax depreciation expense. (In any one year, the depreciation expense for taxes will likely be different from the amount reported on the financial statements.)
It should be noted that depreciation is viewed as a noncash expense. That is, the corporation's cash balance is not changed by the annual depreciation entry. (Often the corporation's cash is reduced for the asset's entire cost at the time the asset is acquired.)
The units of production method of depreciation is based on an asset's usage, activity, or parts produced instead of the passage of time. Under the units of production method, depreciation during a given year will be very high when many units are produced, and it will be very low when only a few units are produced.
To illustrate the units of production method, let's assume that a production machine has a cost of $500,000 and its useful life is expected to end after producing 240,000 units of a component part. The salvage value at that point is expected to be $20,000. Under the units of production method, the machine's depreciable cost of $480,000 ($500,000 minus $20,000) is divided by 240,000 units, resulting in depreciation of $2 per unit. If the machine produces 10,000 parts in the first year, the depreciation for the year will be $20,000 ($2 x 10,000 units). If the machine produces 50,000 parts in the next year, its depreciation will be $100,000 ($2 x 50,000 units). The depreciation will be calculated similarly each year until the asset's Accumulated Depreciation reaches $480,000.
The units of production method is also referred to as the units of activity method, since the method can be used for depreciating airplanes based on air miles, cars on miles driven, photocopiers on copies made, DVDs on number of times rented, and so on.
Depreciation is an allocation technique and the units of production method might do a better job of allocating/matching an asset's cost to the proper period than the straight-line method, which is based solely on the passage of time.
To calculate the gain or loss on the sale of an asset, you compare the amount of cash received for the asset to the asset's book (carrying) value at the time of the sale. If the cash received is greater than the asset's book value, the difference is recorded as a gain. If the cash received is less than the asset's book value, the difference is recorded as a loss.
In order to have the book value at the time of the sale, you must record the depreciation expense up to the date of the sale.
If the asset is exchanged instead of sold, the accounting treatment will often be different.
An asset that is fully depreciated and continues to be used in the business will be reported on the balance sheet at its cost along with its accumulated depreciation. There will be no depreciation expense recorded after the asset is fully depreciated. No entry is required until the asset is disposed of through retirement, sale, salvage, etc.
To illustrate this, let's assume that a machine with a cost of $100,000 was expected to have a useful life of five years and no salvage value. The company depreciated the asset at the rate of $20,000 per year for five years. If the machine is used for three more years, the depreciation expense will be $0 in each of those three years. During those three years, the balance sheet will report its cost of $100,000 and its accumulated depreciation of $100,000 for a book value of $0.
The book value of an asset is the asset's cost minus the asset's accumulated depreciation. For example, in the general ledger account, Automobile, is the automobile's cost of $22,000. In the contra asset account, Accumulated Depreciation on Automobile, is a credit balance of $16,000. The net of those two amounts ($22,000 minus $16,000) is the book value or the carrying value of the automobile. In this example the $6,000 is the amount being reported on the company's books.
You should realize that this book value is not an indication of the market value of the automobile. The market value could be more than $6,000 or it could be less than $6,000. Also don't confuse the accounting book value with the "blue book" or "black book" amounts that are published and show values for automobiles.
The term book value is also used when referring to a company's liability, such as Bonds Payable. The book value of bonds would be the maturity value (or par value) in the general ledger account, Bonds Payable, minus any unamortized amount in the account, Discount on Bonds Payable, and minus any unamortized amount in the account Bond Issue Costs. If the bonds were issued at more than their face (or par or maturity) amount, the book value would be the balance in Bonds Payable plus the balance in Premium on Bonds Payable and minus any amount in the account, Bond Issue Costs.
Lastly, book value is used when referring to the total amount of stockholders' equity appearing on a corporation's balance sheet. Again, this book value is not an indication of the market value of the corporation. It simply indicates the amounts appearing on the books for the assets less the amounts appearing for the liabilities. A corporation can be far more valuable than the amount of its book value.
In the calculation of depreciation expense, the salvage value of an asset is an estimated amount, and the estimated amount is often zero. With the common assumption of no salvage value, the entire cost of an asset used in a business will be depreciated over the asset's useful life.
A noncash expense is an expense that is reported on the income statement of the current accounting period, but there was no related cash payment during the period.
A common example of a noncash expense is depreciation. For instance, if a company purchased equipment on December 31, 2012 for $200,000 cash, it could have Depreciation Expense of $20,000 in each of the next 10 years. As a result its income statement will report Depreciation Expense of $20,000 in each of the years 2013 through 2022. Since there is no cash payment in any of those years, each year's $20,000 of depreciation expense is referred to as a noncash expense.
A plant asset is an asset with a useful life of more than one year that is used in producing revenues in a business's operations. Examples of plant assets include land, land improvements, buildings, machinery and equipment, office equipment, furniture, fixtures, vehicles, leasehold improvements, and construction work-in-progress. Plant assets are also referred to as fixed assets and/or property, plant and equipment.
Plant assets are recorded at cost and depreciation is reported during their useful lives. (However, there is no depreciation of land, and the depreciation for construction work-in-progress begins when the asset is placed into service.) The cumulative amount of depreciation is reported in the contra plant asset account Accumulated Depreciation.
Plant assets and the related accumulated depreciation are reported on a company's balance sheet in the noncurrent asset section entitled property, plant and equipment. Accounting rules also require that the plant assets be reviewed for possible impairment losses.
Assets are resources owned by a company as the result of transactions. Examples of assets are cash, accounts receivable, inventory, prepaid insurance, land, buildings, equipment, trademarks and customer lists purchased from another company, and certain deferred charges.
The term fixed assets generally refers to the long-term assets, tangible assets used in a business that are classified as property, plant and equipment. Examples of fixed assets are land, buildings, manufacturing equipment, office equipment, furniture, fixtures, and vehicles. Except for land, the fixed assets are depreciated over their useful lives.
In financial accounting, scrap value is associated with the depreciation of assets used in a business. In this situation, scrap value is defined as the expected or estimated value of the asset at the end of its useful life. Scrap value is also referred to as an asset's salvage value or residual value. The following example illustrates how the scrap value is used.
A business acquires equipment at a cost of $150,000 and estimates that its scrap value will be $10,000 at the end of its useful life of 7 years. The annual straight-line depreciation expense will be $20,000 [($150,000 cost minus $10,000 scrap value) divided by 7 years]. Accountants and U.S. income tax regulations often assume that for the depreciation calculation the asset will have no scrap value. (If cash is received when the asset is scrapped, any amount that is in excess of the asset's carrying value will be reported as a gain.)
In cost accounting, scrap value often refers to the amount that a manufacturer will receive from materials or products that will be scrapped.
The purchase of equipment that will be used in a business is not reported on the profit and loss statement. However, the depreciation of the equipment will be reported as depreciation expense on the profit and loss statements during the years that the equipment is used.
For example, if a company buys equipment for $100,000 and it is expected to be used for 10 years, the company's profit and loss statements will report depreciation expense of $10,000 in each of the 10 years (assuming the straight-line method of depreciation is used).
The purchase of equipment is shown on the statement of cash flows for the period in which the purchase took place. The equipment will also be reported on the company's balance sheets at its cost minus its accumulated depreciation.
The profit and loss statements are also known as income statements, statements of operations, and statements of earnings.
Depreciation could be an administrative expense, but it can also be a selling expense, and a part of the cost of manufacturer's products.
Where depreciation is reported depends on the assets being depreciated. For example, the depreciation on the building and furnishings of a company's central administrative staff is considered an administrative expense. The depreciation on the sales staff's automobiles is considered part of the company's selling expenses. The depreciation on a manufacturer's factory and production equipment will be included in the overhead cost of the product. When a manufacturer's products are sold, some of the depreciation will be included in the cost of goods sold. When some of the manufactured products are held in inventory, some of the depreciation associated with the manufacturing process will be included in the cost of the inventory.
As you can see, depreciation is often part of many functions within a company. The company's depreciation should be assigned to each of the areas where the assets are utilized.
Depreciation expense is the amount of depreciation that is reported on the income statement. In other words, it is the amount that pertains only to the period of time indicated in the heading of the income statement.
Accumulated depreciation is the total amount of depreciation that has been taken on a company's assets up to the date of the balance sheet. Accumulated depreciation is also the title of the contra asset account reported in the property, plant and equipment section of the balance sheet. The accumulated depreciation for an individual asset is subtracted from the asset's cost in determining the asset's carrying value or book value.
To illustrate, let's assume that a retailer purchases new display racks at a cost of $84,000. This asset is estimated to have a useful life of 7 years (84 months), no salvage value, and will be depreciated using the straight-line depreciation method. Therefore, during each month of the asset's life the retailer will report depreciation expense of $1,000. However, the accumulated depreciation will be reported on the balance sheet at $1,000 after the first month, $2,000 after the second month, $3,000 after the third month, and so on until it reaches $84,000 at the end of 84 months.
Assuming a manufacturer purchases manufacturing equipment for $84,000 with the same life and salvage value, the $1,000 of monthly depreciation will be part of manufacturing overhead (instead of being reported directly on the income statement as depreciation expense). As part of manufacturing overhead it will be allocated to the products manufactured. When the products are sold, their production costs (which include their allocated share of depreciation and other manufacturing overhead costs) will be reported on the income statement as the cost of goods sold. The accumulated depreciation will be reported on the balance sheet just as it was for the retailer.
We will use the following example to illustrate how to divide the cost of real estate into the cost of the land and the cost of the building. Assume that the entire cost of a real estate purchase is $220,000. The appraisal made at the time of the purchase indicates that the land has a market value of $50,000 and the building has a market value of $200,000...for a total market value of $250,000.
We can use the appraisal amounts for dividing the actual cost of $220,000 into the cost of the land and the cost of the building. There are two related techniques which will have the same results.
A self-check of both calculations indicates the same costs: land at $44,000 plus the building at $176,000 equals the total actual cost of $220,000.
We did not deviate from the cost principle. We merely used the appraised market values as a logical way to divide up the actual cost between the land and building. This assignment or allocation is necessary because the cost of the building used in a business will be depreciated, while the cost of the land is not depreciated.
When equipment that is used in a business is sold for cash before it is fully depreciated, there will be two journal entries:
The first entry will be a debit to Depreciation Expense and a credit to Accumulated Depreciation to record the depreciation right up to the date of the sale (disposal).
The second entry will consist of the following:
If the equipment is traded-in or exchanged for another asset, the second journal entry will be different from the one we presented.
The purpose of depreciation is to match the cost of a productive asset (that has a useful life of more than a year) to the revenues earned from using the asset. Since it is hard to see a direct link to revenues, the asset's cost is usually allocated to (assigned to, spread over) the years in which the asset is used.
Depreciation systematically allocates or moves the asset's cost from the balance sheet to expense on the income statement over the asset's useful life. In other words, depreciation is an allocation process in order to achieve the matching principle; it is not a technique for determining the fair market value of the asset.
The accounting entry for depreciation is a debit to Depreciation Expense and a credit to Accumulated Depreciation (a contra-asset account that is reported in the same section of the balance sheet as the asset that is being depreciated).
In short, transactions are first recorded in journals. From the journals the amounts are posted to the specified accounts in the general ledger.
Let's illustrate the difference between entries to the general journal versus general ledger with the depreciation associated with a company's equipment.
The depreciation on equipment is first recorded in the general journal. A journal lists transactions in order by date and is defined as the book of original entry. To record depreciation on equipment in the amount of $10,000, the general journal will show a date, such as December 31, a debit to Depreciation Expense for $10,000 and a credit to Accumulated Depreciation for $10,000.
The amounts in the general journal are then posted to the specified accounts, which are contained in the general ledger. In our example, the account Depreciation Expense will be debited as of December 31 for $10,000 and the account Accumulated Depreciation will be credited as of December 31 for $10,000.
Leasehold improvements should be depreciated or amortized according to the lessee's normal depreciation policy except that the time period shall be the shorter of: 1) the useful life of the leasehold improvements, or 2) the remaining years of the lease. The remaining years of the lease include the years in the lease renewals that are reasonably assured.
A discussion of your question was done by the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB).
The cost of installation is part of the cost of the asset. An asset's cost is considered to be all of the costs of getting an asset in place and ready for use. Therefore, the labor cost of installing a new machine is considered to be part of the asset's cost and not an immediate expense of the period.
The cost of the installation labor will include the workers' wages and the fringe benefits applicable to those wages.
The total cost of the asset, including installation costs, will be depreciated over the useful life of the asset.
The concept of materiality does allow you to expense the installation cost immediately if the amount is insignificant.
Straight line depreciation is likely to be the most common method of matching a plant asset's cost to the accounting periods in which it is in service. Under the straight line method of depreciation, each full accounting year will be allocated the same amount or percentage of an asset's cost. (The total amount of depreciation over the years of the asset's useful life will be the asset's cost minus any expected or assumed salvage value.)
To illustrate straight line depreciation let's assume that a company purchases equipment at a cost of $430,000 and it is expected to be used in the business for 10 years. At the end of the 10 years, the company expects to receive a salvage value of $30,000. Under the straight line method each full accounting year will be allocated $40,000 of depreciation, which is one-tenth (1/10) or 10% of the $400,000 that needs to be depreciated over the useful life of the equipment. If the asset is purchased in the middle of the accounting year there will be $20,000 of depreciation in the first and the eleventh accounting year and $40,000 in each of the years 2 through 10.
In the U.S. a company may use the straight line method for its financial statements while at the same time be using the Internal Revenue Service's faster depreciation on its federal income tax return.
A revenue expenditure is a cost that is expensed in the accounting year in which it is incurred. In other words, the cost will be matched with the revenues of the accounting year in which the expenditure took place. (This is in contrast to a capital expenditure in which the cost is deferred to the balance sheet and is then expensed over several accounting years.)
Revenue expenditures are often discussed with costs spent on fixed assets after they have been placed in service. For example, the amount spent each year to keep an ice cream's store's equipment working efficiently is a revenue expenditure. Also, the cost to repair the equipment will be a revenue expenditure. In both of these situations, the amounts spent will be debited to Repairs and Maintenance Expense and will be matched with the revenues on the current year's income statement.
On the other hand, if the ice cream store incurs a large cost to improve the equipment (to make it more than it had been) and/or to extend the equipment's useful life, the amount spent is considered to be a capital expenditure. As such, the amount is initially deferred to the balance sheet (capitalized) and will be expensed over the current and future years of the equipment's useful life.
Land is not depreciated because land is assumed to have an unlimited useful life.
Other long-lived assets such as land improvements, buildings, furnishings, equipment, etc. have limited useful lives. Therefore, the costs of those assets must be allocated to those limited accounting periods. Since land's life is not limited, there is no need to allocate the cost of land to any accounting periods.
The main advantage of using historical cost on the balance sheet for property, plant and equipment is that historical cost can be verified. Generally, the cost at the time of purchase is documented with contracts, invoices, payments, transfer taxes, and so on.
The historical cost of plant and equipment (not land) is also used to determine the amount of depreciation expense reported on the income statement. The accumulated amount of depreciation is also reported as a deduction from the assets' historical costs reported on the balance sheet. (In the case of impairment, some assets might be reported at less than the amounts based on historical cost.)
The use of historical cost is also a disadvantage to those users of the financial statements who want to know the current values.
I will assume that the project under construction is a major rebuilding of equipment or an addition to a building. The amounts spent on these projects would be debited to a long term asset account such as Construction Work in Progress. This account is often reported as the last line within the balance sheet classification Property, Plant and Equipment.
There will be no depreciation until the project is completed and the asset is placed into service. When the completed asset is placed into service, the project's cost will be removed from the account Construction Work in Progress and will be debited to the appropriate plant asset account.
Residual value, salvage value and scrap value are three terms that refer to the expected value at the end of the useful life of the property, plant and equipment used in a business. This estimated amount is used in the calculation of an asset's depreciation expense, and often the amount is assumed to be zero.
The term residual value can also refer to the estimated value of a leased asset at the end of the lease term.
Depreciation can be either a direct cost or an indirect cost, or it can be both direct and indirect.
Let's illustrate this with the depreciation of a machine used in Department 23 of a manufacturer. The depreciation on that machine is a direct cost for Department 23. It is direct because it is traceable to Department 23 without any allocation.
The depreciation of this same machine will be an indirect cost of the products manufactured with that machine. It is indirect because the depreciation is allocated to the products. Perhaps the machine in Department 23 has depreciation of $50,000 per year (cost of machine of $500,000 divided by 10 years of useful life). The $50,000 of annual depreciation is then assigned or allocated to products based on the number of hours that products use the machine. For example, if the manufacture expects 20,000 machine hours of use in the current year, then it assigns or allocates $2.50 ($50,000/20,000) per machine hour to each product using the machine. If Product #189 requires one hour of this machine's time, Product #189 will have $2.50 as part of its indirect costs. Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, or burden.
Examples of land improvements include paved parking areas, driveways, fences, outdoor lighting, and so on. Land improvements are recorded separately from land, because land improvements have a limited life and are depreciated. Land is assumed to last indefinitely and will not be depreciated.
Land improvements are recorded in a general ledger asset account entitled Land Improvements. The depreciation of land improvements will result in depreciation expense on the company's income tax return. This will reduce its taxable income and will reduce a profitable company's income tax payments.
An example of a leasehold improvement is the permanent improvement to a building that is being rented under a 10 year lease. For instance, the tenant might construct permanent walls and offices inside of the warehouse that it leases from the owner. The lease will likely state that all improvements to the building will belong to the owner of the building. The amount spent by the tenant to improve the building will be recorded by the tenant in its asset account Leasehold Improvements. Generally, the amount of these leasehold improvements will be depreciated by the tenant over the useful life of the improvements or over the life of the lease, whichever is shorter. The depreciation expense associated with the leasehold improvements will reduce the tenant's taxable income and its income tax payments if the company is profitable.
In accounting, salvage value is an estimated amount that is expected to be received at the end of a plant asset's useful life. Salvage value is sometimes referred to as disposal value, residual value, terminal value, or scrap value.
The estimated salvage value is deducted from the cost of the asset in order to determine the total amount of depreciation expense that will be reported during the asset's useful life.
Accountants and income tax regulations often assume that plant assets will have no salvage value. This will result in an asset's entire cost being depreciated during the years that the asset is used in the business.
We charge depreciation because most of the long-lived assets used in a business have 1) a significant cost, and 2) they will be useful only for a limited number of years. The matching principle (a basic underlying accounting principle) requires that the actual cost of these assets be allocated to the accounting periods in which the company will benefit from their use.
The depreciation reported on a U.S. corporation's external financial statements is computed by spreading an asset's cost (less any salvage value) over the asset's service life or useful life. For example, equipment with a cost of $500,000 and no salvage value at the end of an assumed useful life of 10 years will likely result in matching $50,000 to each full accounting year. (The U.S. income tax rules allow accelerating the depreciation amounts, but the total cannot exceed the asset's cost.)
Examples of the assets that must be depreciated include machinery, equipment, fixtures, furnishings, buildings, vehicles, etc. These assets are often referred to as fixed assets or plant assets, and the amounts spent are part of a corporation's capital expenditures. (Note that land is not depreciated because it is assumed to last indefinitely.)
Accumulated Depreciation reports the amount of depreciation that has been taken from the time an asset was acquired until the date of the balance sheet. The cost of an asset minus its accumulated depreciation is the asset's carry value or book value.
Since depreciation is an allocation of an asset's cost based on the estimated useful life, you should not assume that the depreciation is an indicator of what's occurring to the asset's market value. For example, a building in an excellent location may be increasing in value even though depreciation is taken. The present market value might be three times the original cost and yet the accumulated depreciation is now equal to the asset's cost—meaning its book value is $0.
The amount reported in Accumulated Depreciation merely reports the total amount of an asset's cost that has been sent over to the income statement as Depreciation Expense since the asset was acquired.
If the car continues to be used after it is fully depreciated, there will be no further depreciation entries.
If you sell the car after it is fully depreciated, you
If the earlier depreciation amounts assumed a salvage value of zero, the gain will equal the cash received.
The units of activity depreciation is one of several methods of depreciation. The units of activity method of depreciation is unique in that a plant asset's useful life is expressed in the total units that are expected to be produced or the asset's total activity during its life. The asset's cost is then allocated to the accounting periods based on the plant asset's usage, units produced, activity, etc. Years and partial years are not relevant when using this depreciation method. (The other methods of depreciation express the plant asset's useful life in years and will allocate the plant asset's cost based on the mere passage of those years. Under these methods partial years are relevant.)
To illustrate the units of activity method of depreciation, let's assume that a company acquires a finishing machine that is expected to perform the finishing operation on a total of 100,000 units of product. The machine has a cost of $225,000 and is expected to have a salvage value of $25,000. Under the units of activity method, the company will record $2 of depreciation whenever it finishes a product. The $2 is computed as follows: ($225,000 - $25,000) divided by the expected 100,000 units of product. In an accounting year when 8,000 units are finished, the depreciation will be $16,000. In a year when 23,000 units are finished, the depreciation will be $46,000. The depreciation will continue until a total of $200,000 of depreciation has been taken (and the book value will be $25,000).
Most companies will not use the double-declining balance method of depreciation on their financial statements. The reason is that it causes the company's net income in the early years of an asset's life to be lower than it would be under the straight-line method.
One reason for using double-declining balance depreciation on the financial statements is to have a consistent combination of depreciation expense and repairs and maintenance expense during the life of the asset. In other words, in the early years of the asset's life, when the repairs and maintenance expenses are low, the depreciation expense will be high. In the later years of the asset's life, when the repairs and maintenance expenses are high, the depreciation expense will be low. While this seems logical, the company will end up reporting lower net income in the early years of the asset's life (as compared to the use of straight-line depreciation). Most managers will not accept reporting lower net income sooner than required.
Fully depreciated assets that continue to be used are reported at cost in the Property, Plant and Equipment section of the balance sheet. The accumulated depreciation for these assets is also reported in this section. As a result, the combination of these assets' costs minus their accumulated depreciation will likely be a net amount of zero. This net amount is the carrying amount, carrying value or book value.
The cost and accumulated depreciation will continue to be reported until the company disposes of the assets. The disposal might be the sale or the retirement of the assets.
Fully depreciated assets and their resulting book value of zero reinforces accountants' position that depreciation is a process to allocate assets' costs to expense; it is not a process for valuing assets.
Some people state that depreciation is a source of funds or a source of cash.
Depreciation expense is reported as a positive amount on the statement of cash flows prepared under the popular indirect method. However, the reason it is listed is to adjust the net income amount that had been reduced by depreciation expense on the income statement. (Recall that the depreciation entry debits Depreciation Expense and credits Accumulated Depreciation—the cash account is not involved.) In other words, the positive depreciation amount reported on the statement of cash flows is merely one of the adjustments needed to convert the accrual net income to the cash provided from operating activities. Depreciation is not a source of cash.
Let's illustrate this with some amounts. A sidewalk florist operates a cash only business. During the most recent year, this florist had cash revenues of $100,000. Its expenses included $70,000 of cash expenses and $8,000 of depreciation expense on its truck that was purchased in an earlier year. During the year there were no other revenues or expenses, and the florist's cash balance increased by $30,000. The florist's income statement will report net income of $22,000 (revenues of $100,000 minus expenses of $78,000).
The florist's statement of cash flows prepared under the indirect method will begin with net income of $22,000. It will then add the $8,000 of depreciation expense. The result is cash provided by operating activities of $30,000—which agrees to the business's change in its cash balance.
The $8,000 of depreciation expense was not a source of cash, even though it appears as a positive amount on the statement of cash flows.
Editor's note: A reader's comment points out that the depreciation on the income tax return will reduce taxable income and that in turn will likely reduce the amount of cash paid for income taxes. This reduction in income taxes is a source of cash.
In the U.S. the use of the word reserve has been discouraged for several decades. In its place, the accounting profession has recommended the use of words such as allowance, accumulated, or provision. For instance, many years ago the contra account to a plant asset may have been titled Depreciation Reserve.
To some readers, that name implied that cash had been set aside to replace the asset. To better communicate reality, the accounting profession recommended a more descriptive title such as Accumulated Depreciation. Similarly, the contra account to Accounts Receivable may have been titled Reserve for Bad Debts. Again, that title could imply that money was set aside. To avoid misinterpretation, the accounting profession suggested Allowance for Bad Debts or Provision for Bad Debts.
The word provision might appear in the title of a contra account as we just noted. In addition, provision will occasionally appear in the title of an expense account, such as Provision for Income Taxes.
In accounting the terms depreciation, depletion and amortization often involve the movement of costs from the balance sheet to the income statement in a systematic and logical manner.
For example, the systematic expensing of the cost of assets such as buildings, equipment, furnishings and vehicles is known as depreciation. The systematic expensing of the cost of natural resources is referred to as depletion. The systematic expensing of other long-term costs such as bond issue costs and organization costs is referred to as amortization.
Depreciation, depletion and amortization are also described as noncash expenses, since there is no cash outlay in the years that the expense is reported on the income statement. As a result, these expenses are added back to the net income reported in the operating activities section of the statement of cash flows when it is prepared under the indirect method.
The term amortization is also used to indicate the systematic reduction in a loan balance resulting from a predetermined schedule of interest and principal payments.
Capitalize refers to adding an amount to the balance sheet. For example, certain interest from loans to self-construct a building will be added to the cost of the building. The building's cost including the capitalized interest will be recorded as an asset on the balance sheet.
Depreciate refers to reducing an amount reported on the balance sheet. Depreciation is defined as systematically allocating the cost of a plant asset from the balance sheet and reporting it as depreciation expense on the income statement. If the building has a cost of $600,000 and a useful life of 30 years, then (assuming no salvage value and straight-line depreciation) each year $20,000 of cost is removed from the asset section of the balance sheet and will appear on the income statement as depreciation expense. (This in turn reduces owner's equity and keeps the balance sheet in balance.)
The interest on debt that is capitalized will not be expensed during the year of construction. Instead, it is added to the cost of the building (capitalized) and will be part of the annual depreciation expense occurring during the building's 30-year life.
In summary, capitalize means to add an amount to the balance sheet. Depreciate means to systematically remove an amount from the balance sheet during the asset's useful life.
When long-term assets are sold, the amounts received are referred to as the proceeds.
If the amount of the proceeds is greater than the book value or carrying value of the long-term asset at the time of the sale, the difference is a gain on the sale or disposal. If the amount received is less than the book value, the difference is a loss on the sale or disposal. Depreciation must be recorded up to the date of the disposal in order to have the asset's book value at the time of the sale.
On the statement of cash flows, the proceeds from the sale of long-term assets are reported in the investing activities section, while the gain on the sale appears in the operating activities section as a deduction from net income.
Yes, many companies use two or more methods of depreciation.
It is acceptable and common for companies to depreciate its plant assets by using the straight line method on its financial statements, while using an accelerated method on its income tax return.
A company could also be depreciating its equipment over ten years for its financial statements, while using seven years for its income tax return.
Even the depreciation for financial statements could consist of some assets being depreciated using the units of production or units of activity method, while other assets are depreciated using the straight line method.
Capital expenditures or capex are the amounts spent for tangible assets that will be used for more than one year in the operations of a business. Capital expenditures can be thought of as the amounts spent to acquire or improve a company's fixed assets. Some examples include the purchase of machinery, equipment, furniture, building improvements, computer information systems, and leasehold improvements.
The amount of capital expenditures for an accounting period is reported in the cash flow statement. The amount is an outflow of cash and is listed in the investing activities section of the statement. Sometimes the amount is listed as capital expenditures and sometimes it is listed as purchase of property and equipment.
The capital expenditures will also increase the respective asset accounts which are reported in the noncurrent asset section of the balance sheet entitled property, plant and equipment. Once the assets are placed in service they are depreciated over their useful lives. The accumulated depreciation for the assets is also reported as part of the property, plant and equipment.
The current period's amount of capital expenditures is often subtracted from the cash from operating activities to arrive at the company's free cash flow.
The balance in the account Accumulated Depreciation will be reduced when an asset that has been depreciated is removed.
When an asset is sold, the depreciation expense is first recorded up to the date of the sale. Then the asset and its accumulated depreciation is removed and the proceeds are recorded.
Here's an example. A company has Equipment of $600,000 and Accumulated Depreciation of $380,000 before an item of equipment is sold. The original cost of the equipment being sold was $50,000. The first step is to record the current period's depreciation on that one item. Let's assume the depreciation will be $500. Let's also assume that after it is recorded, the item's accumulated depreciation will be $40,500. The company receives $5,000 for the equipment. The journal entry to record the disposal will consist of a debit to Cash for $5,000; a debit to Accumulated Depreciation for $40,500; a debit to Loss of Disposal of Asset for $4,500; a credit to Equipment for $50,000.
Prior to this transaction, the balance in the Accumulated Depreciation account was a credit balance of $380,000. The asset's current period depreciation of $500 increased the account's credit balance to $380,500. The disposal of the asset will reduce the balance in Accumulated Depreciation by $40,500 to a new balance of $340,000.
Depreciation begins when you place an asset in service and it ends when you take an asset out of service or when you have expensed its cost, whichever comes first.
For financial statements, you are guided by the matching principle. The objective is to match the cost of the asset to the accounting periods in which revenues were earned by using the asset. There are two estimates needed: 1) the number of years that the asset will be used, and 2) the salvage value at the end of the asset's use. If an asset has a cost of $100,000 and is expected to be used for 10 years and then have no salvage value, most companies will depreciate the asset at the rate of $10,000 per year. This is known as the straight line method of depreciation.
For income tax purposes in the U.S., the Internal Revenue Service has determined the number of years that various assets will be useful and it assumes there will be no salvage value. The IRS also allows companies to take larger depreciation deductions in the earlier years and smaller deductions in the later years of the assets' lives. This is known as accelerated depreciation.
As you probably noted from the above information, in any one year the depreciation expense on the financial statements will be different from the depreciation expense on the income tax return. However, over the life of an asset, the total depreciation expense will be the same. Accountants refer to this as a timing difference.
The fixed asset turnover ratio shows the relationship between the annual net sales and the net amount of fixed assets.
The net amount of fixed assets is the amount of property, plant and equipment reported on the balance sheet after deducting the accumulated depreciation. Ideally, you should use the average amount of net fixed assets during the year of the net sales.
A corporation having property, plant and equipment with an average gross amount of $10 million and an average accumulated depreciation of $4 million would have average net fixed assets of $6 million. If its net sales were $18 million, its fixed asset turnover would be 3 ($18 million of net sales divided by $6 million of average net fixed assets).
An asset's useful life is the period of time (or total amount of activity) for which the asset will be economically feasible for use in a business. In other words, it is the period of time that the business asset will be in service and used to earn revenues.
Because of the advances in technology, an asset's useful life is often less than its physical life. For example, a computer may be useful for only three years even though it could physically be operated for decades.
The useful life (as well as the salvage value at the end of the useful life) are estimated amounts needed in the calculation of the asset's depreciation. Depreciation is required so that the company's financial statements comply with the matching principle.
In the U.S., income tax regulations specify the useful life that must be used for income tax reporting. This is one reason that in a given year the depreciation on a company's income tax return will not agree with the depreciation reported on its financial statements.
The net book value of a noncurrent asset is the net amount reported on the balance sheet for a long-term asset.
To illustrate net book value, let's assume that several years ago a company purchased equipment to be used in its business. The equipment's cost was $100,000 and its accumulated depreciation as of its recent balance sheet date was $40,000. This means that up to the balance sheet date $40,000 of the asset's cost had been reported as Depreciation Expense. It also means that the equipment's net book value is $60,000 ($100,000 of cost minus $40,000 of accumulated depreciation). Net book value or simply book value indicates that $60,000 of the noncurrent asset's cost has not yet been charged to depreciation expense.
Net book value or book value can also be associated with noncurrent assets other than fixed assets. Two examples include long-term investments and unamortized bond issue costs.
More than 60 years ago, accountants in the U.S. used Reserve for Bad Debts as the title of the contra account associated with Accounts Receivable or Loans Receivable. They also used Reserve for Depreciation as the title of the contra account associated with plant assets. The use of the word reserve led some readers of the financial statements to conclude that money was set aside for replacing plant assets or the uncollectible accounts or loans.
To avoid this misunderstanding, the accounting profession recommended that the word reserve have a very limited use. Accountants now use Allowance for Doubtful Accounts or Allowance for Bad Debts instead of Reserve for Bad Debts. In the case of plant assets, Accumulated Depreciation is used in place of Reserve for Depreciation.
Depletion is the movement of the cost of natural resources from a company's balance sheet to its income statements. The objective is to match on the income statement the cost of the natural resources that were sold with the revenues of the natural resources that were sold. The cost of the natural resources sold is referred to as depletion expense.
The purchase of a new machine that will be used in a business will affect the profit and loss statement, or income statement, when the machine is placed into service. At that point, depreciation expense will begin and there will likely be other expenses such as wages, maintenance, electricity, and so on.
Since the income statement reports only the expenses that match the revenues during the accounting period, the depreciation expense might be very small in the first accounting period compared to the amount spent for the machine. For example, if the machine is purchased half way into the accounting year and its cost was $300,000, the depreciation for that first accounting period might be only $15,000—assuming it has a 10 year life and no salvage value. In the next accounting period the depreciation expense will be $30,000 under the straight-line method.
If the machine is used by a manufacturer, the depreciation, electricity, and maintenance of the machine will be recorded as manufacturing overhead. This overhead is then assigned to the products and will be held in inventory until the goods are sold. When the products are sold, these overhead costs will be reported on the income statement as part of the cost of goods sold.
In depreciation, the mid-month convention means that an asset placed into service during a given month is assumed to have been placed into service in the middle of that month. For example, if you place a warehouse into service on October 6, you will assume it was placed into service in the middle of October and will record depreciation for half of the month of October. If a building is placed into service on October 23, you will assume it was placed into service in the middle of October and will record depreciation for half of the month of October.
The mid-month convention also applies to the disposal of an asset. This means that an asset that is disposed of on October 25 will be assumed to have been disposed of in the middle of October. If an asset is disposed of on October 3, it is also assumed that the asset was disposed of in the middle of October. In either situation, depreciation will be recorded for half of the month of October.
The mid-month convention is pertinent for the income tax depreciation for certain property. You can find more on this in the Internal Revenue Service Publication 946.
Accelerated depreciation is the allocation of a plant asset's cost in a faster manner than the straight line depreciation. Compared to straight line depreciation, accelerated depreciation will mean 1) more depreciation in the earlier years of an asset's life and 2) less depreciation in the later years of the asset's life. [Note that the total amount of depreciation over the asset's life will be the same regardless of the depreciation method used.] Hence, the difference between accelerated depreciation and straight line depreciation is the timing of the depreciation.
Three examples of accelerated depreciation methods include double-declining (200% declining) balance, 150% declining balance, and sum-of-the-years' digits (SYD).
The U.S. income tax regulations allow a business to use accelerated depreciation on its income tax return while using straight line depreciation on its financial statements. For profitable corporations this will likely result in deferred income tax payments being reported on its financial statements.
Some people refer to land, buildings, and machinery as fixed assets. They are also referred to as plant assets, or as property, plant, and equipment.
The depreciation expense on the buildings and machinery is often viewed as a fixed cost or fixed expense. Hence, in the calculation of the break-even point, the annual depreciation expense on the fixed assets other than land is part of the fixed costs or fixed expenses. There is no depreciation of land.
Systematic and rational allocation is a phrase often cited in the definition of depreciation. In that context it means that the annual depreciation expense should be based on a formula that is logical and acceptable to other unbiased accountants.
For example, depreciating an asset over a 10-year period with the same amount of depreciation expense each year is systematic and rational. Depreciating the asset on the basis of the number of parts it produces is also systematic and rational. However, determining the annual depreciation expense based on each year's profits is not systematic and rational.
A decrease in accumulated depreciation will occur when an asset is sold, scrapped, or retired. At that point, the asset's accumulated depreciation and its cost are removed from the accounts. (The net of these two amounts—known as the book value or carrying value—is then compared to the proceeds to determine if there is a gain or loss on the disposal.)
Some accounting textbooks state that the cost of an expenditure that extends the useful life of an asset should be debited to the accumulated depreciation account instead of the asset account. Such an entry will also reduce the credit balance in the accumulated depreciation account.
No. A fully depreciated asset cannot be revalued because of accounting's cost principle, matching principle, and going concern assumption.
For instance, let's assume that a company purchased a building 30 years ago at a cost of $600,000. The company then depreciated the building at a rate of $20,000 per year for 30 years. Today the building continues to be used by the company and it plans to continue using it for many more years. The company's current balance sheet will report the building at its cost of $600,000 minus its accumulated depreciation of $600,000. In other words, the building will be reported at its book value of $0.
The cost principle prevents the company from recording and reporting more than its actual cost of $600,000. The matching principle requires that only the actual cost of $600,000 can be allocated or matched to the years in which the company benefits from the use of the building. Lastly, the company is assumed to be a going concern and therefore it is not liquidating. Hence the amount that the company would receive if it sold the building is not appropriate for its financial statements.
Even if the building's current value is estimated to be $2 million, the financial statements must report the actual cost and the depreciation based on that cost—even if this means reporting a book value of $0. It also means there will be no additional depreciation expense reported after the $600,000 of actual cost has been reported as depreciation expense.
Cost behavior often changes outside of the relevant range of activity due to a change in the fixed costs. When volume increases to a certain point, more fixed costs will have to be added. When volume shrinks significantly, some fixed costs could be eliminated.
Here's an illustration. A company manufactures products in its 100,000 square foot plant. The company's depreciation on the plant is $1,000,000 per year. The capacity of the plant is 500,000 units of output and its normal output is 400,000 units per year. When the company is manufacturing between 300,000 and 500,000 units, it needs salaried managers earning $400,000 per year. Below 300,000 units of output, some of the salaried manager positions would be eliminated. Above 500,000 units, the company will need to add plant space and managers.
For this example, the relevant range is between 300,000 units and 500,000 units of output per year. In that range the total of the two fixed costs is $1,400,000 per year. Below 300,000 units, the fixed costs will drop to less than $1,400,000 because some salaries will be eliminated and some of the space might be rented. When the volume exceeds 500,000 units per year, the company will need to add fixed costs because of the additional space and the additional managers. Perhaps the total fixed costs will be $2,000,000 for output between 500,000 units and 700,000 units.
In 1979 the Financial Accounting Standards Board (FASB) issued its Statement of Financial Accounting Standards No. 33 entitled Financial Reporting and Changing Prices. (You will find the original Statement No. 33 on www.FASB.org.) In short, Statement No. 33 required large companies to report supplementary information on the effects of changing prices on its inventory and its property, plant and equipment. (In the late 1970's the U.S. was experiencing double-digit inflation rates and the SEC was advocating the reporting of replacement cost.)
One disclosure required by Statement 33 was the reporting of the effects of general inflation as indicated by the change in the consumer price index. In other words, a large company had to disclose in the notes to its financial statements some key amounts after adjusting inventory and property, plant and equipment amounts for the changes in the purchasing power of the U.S. dollar. The second disclosure reported the effects of the changes in the specific prices of inventory and property, plant and equipment.
In 1986 the FASB issued its Statement No. 89 which no longer required the reporting of the information. As a result, most companies stopped the calculations and reporting. Two of the factors in deciding to stop the calculations was the lack of use by financial analysts and a decline in the rates of inflation in the U.S. In other words, the accounting for price level changes failed to pass the cost/benefit test.
Using accelerated depreciation on the income tax return will mean greater depreciation expense and smaller taxable income in the earlier years of an asset's life. However, it will be followed by smaller depreciation expense and greater taxable income in the later years of the asset's life.
For a corporation with consistent taxable income, the use of accelerated depreciation on the income tax return instead of the straight-line method, will defer some income tax until the later years of an asset's life. Over the entire life of the asset, the total depreciation expense is the same. The methods merely affect the timing of the depreciation.
It is also important to note that a corporation may use the straight-line method on its financial statements and at the same time use accelerated depreciation on its income tax returns. The differences in income taxes resulting from using different methods are referred to as timing differences or temporary differences.
Illusory profit, also called phantom profit, is the difference between 1) the profit reported using historical costs required by US GAAP, and 2) the profit computed using replacement costs. Illusory profit is greatest during periods of rising costs at companies with significant amounts of inventory and plant assets.
For example, when inventory is measured by using the first-in, first-out cost flow assumption under US GAAP, the actual historical cost of inventory that is charged to the cost of goods sold during periods of rising costs is smaller than the amount computed using replacement costs. This smaller amount of costs charged to the income statement means reporting greater profit. The difference in the profit is said to be illusory.
In the case of plant assets used during periods of rising costs, the depreciation expense reported on the income statement based on historical costs (required by US GAAP) will be less than the depreciation computed by using the higher replacement cost of the plant assets. The additional profit from this difference in depreciation is considered to be illusory profit.
Repairing and maintaining office equipment is an immediate expense. This is true even if the repair cost is a very large amount.
If a large expenditure is made to improve office equipment, that cost would be recorded as an asset and then depreciated over the remaining life of the equipment.
Small expenditures to improve office equipment are usually expensed immediately because of the materiality concept. This means the amount is so small that no one will be misled by having the entire amount appear immediately as an expense rather than appearing as depreciation expense over several years. Often improvements of less than $500 or $1,000 are considered immaterial and are expensed immediately.
It is necessary to allocate a lump sum payment to individual items in order to record a fair portion of the lump sum in each of the proper general ledger accounts.
For instance, let's assume that a corporation made a lump sum payment of $450,000 in order to acquire a building, the land on which the building sits, and also some equipment. The lump sum payment means that the total cost of $450,000 has to be allocated among three general ledger accounts: Land, Buildings, and Equipment. The allocation must be done in a logical manner for the following reasons:
If the cement work was done to repair or maintain existing cement work, then the expenditure should be recorded as an expense. Even if the cost is very large, repairs and maintenance must be expensed. The cost of repairs or maintenance cannot be recorded as an asset.
If the cement work is an addition or an improvement (more than repairing or maintaining existing cement work), the cost of the cement work is viewed as a new asset. If the amount is significant, you should record the expenditure as an asset and then depreciate the cost over the useful life. However, if the amount of the addition or the improvement is relatively small, the accounting concept of materiality allows you to expense the entire amount immediately.
For the company's financial statements, the economic life of the asset should be used—not the years of useful life required for income tax purposes. In other words, the Internal Revenue Service (IRS) might stipulate that certain equipment is to be depreciated on the income tax return over 7 years. However, the company knows that the equipment will be useful in producing revenues for 10 years. Accounting's matching principle requires that the company's financial statements match the equipment's costs to its revenues over a 10-year period. (This will result in the most accurate measurement of the company's accounting net income.)
However, on the tax return the company must follow the IRS rules and will depreciate the asset over 7 years. Obviously, this will result in two sets of depreciation amounts. (Further, the company's financial statements can use straight-line depreciation over the 10 years while the income tax return is using an accelerated method of depreciation over the 7 years.)
The difference in each year's depreciation is referred to as a timing difference. The reason is that over the life of the equipment, the total amount of depreciation expense is likely to be the same. It is just a matter of timing as to when that total amount is reported on the financial statements versus the income tax returns.
A plant asset's cost is depreciated, unless the asset is land.
Cost is defined as the cash or cash equivalent amount at the time of the transaction. This means that the asset's cost is the cash amount plus the note's present value at time that the asset is purchased.
To illustrate this, let's assume that equipment is purchased by giving $50,000 of cash plus a promissory note of $100,000. If the note has an interest rate that is a fair rate considering the market rates and the riskiness of the party signing the note, then the present value of the note is $100,000. The equipment will then be recorded at its cost of $150,000. This cost of $150,000 will be depreciated over the equipment's useful life.
If the note specifies zero interest, then the present value of the note is less than $100,000. Let's assume that the note's present value is computed to be $90,000. This means that the asset's cost will be $140,000—the cash of $50,000 plus the note's $90,000 of present value. Assuming no salvage value, the total depreciation expense over the life of the equipment will equal $140,000. The $10,000 difference will be reported as interest expense over the life of the note.
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